Stock Options

September 30, 2010

If
you’re joining a company or have been offered stock options at your
current job, there are some things you should understand about stock
options if you want to negotiate effectively.

The complexity of an accompanying “Employee Stock Plan” and the
formality of a stock option offer can be off-putting. But, you don’t
have to know a lot to be effective in stock option negotiation. If
you have command of how much options are worth, what is fair in terms of
option amount, the nature of key terms, potential tax liability, and
the power of now, you will be positioned to make the best deal you can.

Understand the mathFirst
thing's first, look at the options themselves. The stock options
cannot be understood without knowing the "entire fraction" -- that is to
say that options offered to you are the numerator of a fraction.
Knowledge of the whole fraction, (the numerator as well as the
denominator), is the starting point for evaluating a stock option.

To be explicit, having 3,000 stock option shares in a company with
30,000 total shares is having 10%. So, if you are offered 200 stock
options in a company with 30 million shares, it’s nice but it may not be
all that profitable. Here again, the value of the shares is the
ultimate determinant of value but you can't discern too much of anything
based upon the raw number of options (the numerator alone).

Know what is fairMost
companies establish acceptable stock option grant ranges for certain
positions and associated salaries. What is the range for your position
and where are you in that range? What would it take to get above the
range? If the answer is you can’t be offered an amount of options
outside the pre-determined range, push back on the salary as a
negotiating technique. Either way, seek whatever is fair and
appropriate to the position.

If you’re considering an executive position at a company with
existing initial investors, be aware the company will also need to
support a CEO, three VP's and five to seven directors with incentive
stock options from the stock option pool. While circumstances vary
widely to affect the proper amount of options associated with an
executive position, the general consensus for various positions is the
following:

CEO - Option Grant of 4 to 8%VP's - Options of 2 to 3% CFO - Options of 1to 3%Directors - Options of 1/2% or less

Founder CEOs with shares or other particular facts may influence
these numbers and all generalizations are dangerous. The right amount
for any situation is, and should be, the focus of a fair amount of
discussion.

Comprehend the key termsThe key terms with stock options relate to the price and vesting of the options. What the price is can be relatively straightforward while how the price is determined is not. More on that in a moment.

Vesting means that you earn the right to buy the options over a
period of time. Your right vests over time. For example, if the stock
option specifies you get 1,000 stock options priced at $1.00 with a
vesting period of four years, you can buy 250 shares annually for four
years. You don’t have to buy them then, but you have the right to buy
them then. If you stay in the employ of the granting company, you may
have the right to buy the vested options over 5, 7 or 10 years. You
should know the vesting schedule and how long you can buy your vested
options.

The price of a stock option is another matter. Stock options are
designed and intended by most companies to be valueless on the day they
are granted so they don’t create a taxable event in the eyes of the
Internal Revenue Service. If you were granted 1,000 shares priced at
$2.00, for example, when the fair market value was really $5.00 per
share – the I.R.S. views the difference of $3,000 as taxable income.

So the fair market value of the option on the date of the grant is
important. (Which is why most stock option scandals relate to “back
dating” the options to hide the income effect of granting options priced
lower than fair market value). But how does one determine the fair
market value of a private company stock option that by definition isn’t
sold in any open or efficient stock market?

It can be tough to do well and some specialty financial firms exist
almost solely to provide that answer for a fee. In any case, your
questions need to be oriented to the timing and source of the
valuation. Remember if the options are priced incorrectly, you will
personally owe the taxes. The I.R.S. reserves the right of 20/20
hindsight on this pricing event. The company will also be liable for
incorrect pricing. What you need to determine is that a professional
effort was made to correctly price the options. For a public company
employee receiving options, this is much simpler because the pricing is
determined by the closing price of the stock on the date of the option
grant.

Be ready to pay the taxesThe premise
underlying stock option value is that you will be able to buy the stock
in the future at today’s lower price. And yes, when you actually buy
the option or “exercise it”, you are liable for the taxes associated
with the profit income. So if you exercise 250 shares at $1 by
purchasing the option for a stock that is worth $5 per share, your
income from a tax point of view is the $1,000 profit total from the $4
profit per share. This is true even if you don’t turn around and sell
these shares as soon as you purchase them.

There are many tales of woe around people buying stock at $1 when it
is worth $5 and waiting to sell the shares, only to sell at $3 per
share. In this example, the taxes are determined from the paper profit
regardless of the actual profit. Does this mean that you should sell the
option on the day you exercise it? For most people, the short answer
is yes. In any case, one should understand the taxable event and
liability. And be ready to pay.

Be aware of the momentIf
your options become more valuable over time, tomorrow’s options will
become scarcer and harder for you to get more of as a result. So the
moment to get stock options is always now. Tomorrow’s options should be,
if things are going well, higher priced. There will be fewer to give
away because the original amount of shares set aside for option grants
tends to diminish over time.

Yes, the company could just simply issue or create more shares for
option grants but you need to realize that doing so decreases the value
of all existing shares. And remember that the people that need to
support the additional share creation are the shareholders who will in
fact be hurt by the decrease in share value. The short answer is that
everyone acts in their economic self interes,t and as options become
more valuable, they become harder for employees to get.

Stock options have been a material wealth source for the employees of
many companies. For most people, they are an arcane subject if not an
apparently complex one. But given the money at stake, having a working
understanding of the issues and dynamics is well worth the time.

June 01, 2009

From time to time, I will write about some of the terms and conditions of employee stock option plans that can have a major impact for the founder(s) at the end of the day. Given reader response to my previous blogs on the option subject, I want to call attention to vesting.

The vesting of stock options over some designated period can have dramatic economic impact for founders.

Vesting

Stock option plans will have a vesting period where the right to purchase the granted stock options increases annually and sometimes monthly. So the stock optionee gets 1,000 options that vest over a four year period in quarterly amounts, meaning that employee vests and has the right to purchase the options following the completion of each year of employ. In our example, Employee has the right to buy to 25o options after year one of employment. The Employee will usually have that right for some period of time so long as they stay in the employ of the company. It can be up to 10 years to purchase the vested options.

The question arises -- if the founder is the source of the original stock options to supply the stock option pool -- where do ungranted or un-vested options go when the company sells? Consider an example where the ungranted and granted but un-vested options total 10% of the company at the time of company sale. These options were all originally the founders' shares. Where do they typically go at exit? The custom is for them to divided on a pro rata basis amongst existing shareholders. So if investors hold 70% of the company and management/founders hold 30%, then the shares will go 70% to the investors and 30% tothe founders/management.

In this oversimplified example, the issues are obvious. In real life, the sale frequently occurs after the original option pool has long been exhausted and the bulk of the options are vested to the grantees. That said, better to be in command of the issue than not.

November 14, 2008

So you been offered 3,000 or 200 or 15,000 or 100,000 stock options in a start up? What does that mean? How do you determine their worth now? What should you expect them to be worth later?

First things first, let's look at the options themselves. The stock options cannot be understood without knowing the "entire fraction" -- that is to say that the offered options are the numerator of a fraction. To know the whole fraction, meaning the numerator as well as the denominator is the starting point for evaluating a stock option. Having 3,000 stock option shares in a company with 30,000 total shares is 10%. Having 200 stock options in a company with 30 million shares is nice but it may not be all that profitable. Here again, the value of the shares is the ultimate determinant of value but one can't discern too much of anything based upon the raw number of options (the numerator alone).

The options should be worth nothing when they're granted. Since options usually vest over time and the U.S. tax laws dictate that unless the options are provided to you at today's cost then it it is a current taxable event, one wants them to be worthless on the day they are granted. If the options are granted at less than the fair market value, then the granting of them creates a taxable event. So, the correct answer is that the options are valueless when you receive them.

So what will they be worth? Knowledge of the numerator and denominator is necessary to begin this estimate. What will the company be worth in 2, 3, or 4 years? This answer is typically derived at looking at the valuation of public companies in the same or comparable industries. The key ratio is usually the sales multiple. That is what is the value of the company expressed as a multiple of its sales. A company with $50M in sales that has a market capitalization of $200M has a sales multiple of 4. So, what are the common sales multiples in your industry? With that number in hand, the equation becomes estimated sales of your company times the industry sales multiple times your ownership fraction. Or, $50M times 4 equals $200M and your .25% options equate $500,000. So a little can be a lot with stock options. Or a lot of options can be worth a little.

September 26, 2008

One area of interest to investors and entrepreneurs alike is the size of the employee stock option pool post financing and the "typical" grant sizes for key employees.

As a rule of thumb, one should assume that a post A Round company will need to support a CEO, three VP's and 5 to 7 directors with incentive stock options from the stock option pool. And while circumstances vary widely to affect the proper amount of options to a position, the general consenus is the following for various positions:

CEO - Option Grant of 4 to 8%

VP's - Options of 2 to 3%

CFO - Options of 1to 3%

Directors - Options of 1/2% or less

All of which dictates a need for an option pool amount around 20% of the post A round share amount. Founder CEO's with shares or other particular facts may influence this and all generalizations are dangerous.

The right amount for any situation is and should be the focus of a fair amount of discussion.